Plansmith Blog

Understand the Behavior of Interest Rate Risk

Posted by Craig Hartman on 2/25/19 2:27 PM

The purchase of an asset liability management (ALM) system presents a problem to many bankers. Often the process begins with the creation of a checklist of features and functions then progresses to comparing vendors. The vendor with the highest "score" wins. While this may be a good start, there are dimensions to the problem that this ignores, specifically the quality and significance of the features identified.

The most difficult obstacle is the realization that ALM is not an accounting problem. Risk, by definition, deals with uncertainty. Accounting is not the tool of choice for dealing with uncertainty. Accounting is history based where risk management requires a future perspective.

For example, the rate sensitivity gap has taken on accounting characteristics as ALCOs spend most of their time auditing the accuracy of the maturity data as if greater precision will yield greater accuracy. In the context of managing uncertainty, this is like polishing grains of rice. No one ever compares what the gap report said should happen with what did happen. If they did, they would find that margin seldom moves in the way the gap report predicted. So, why do community bankers still use it? Because it has a logical appeal and it fits an accounting paradigm, even though it is irrelevant as margin movement does not follow the gap.

Interest rate risk management requires that we understand the behavior of those factors which affect margin and shareholder value. These factors include the behavior of interest rates themselves, the behavior of competitors in response to rates, and the behavior of customers in response to rates. Management of the risks associated with interest rates is an art, not a science. There are no absolute answers, only directions.

Community bank and credit union ALM models teach the user about risk possibilities and allow for stress testing or "what-if" strategies in an efficient way.

Click here to schedule a discovery call or to learn how Plansmith can help eliminate the pain and frustration of ALM.

Topics: interest rate risk, community bank ALCO, community bank interest rate risk, community bank budgeting, credit union planning